For more honesty with stock options

Earlier this month, corporate lobbyists worked overtime to kill bipartisan legislation that would require firms to treat stock options as any other business expense.

So what, you may be thinking. In fact, the ability of companies not to report these options – which grant an employee the right to purchase discounted company stock in the future – remains a critical defect in corporate governance. Congress still must fix the problem, to instill more honesty in how companies report the bottom line and to boost public confidence in Corporate America.

Under current rules, unexercised stock options do not have to be reported on a company's books, unlike wages and other expenses. Defenders of the status quo argue that the exemption encourages use of options. This is a good thing, they say, because options promote entrepreneurship, align executive decisions with shareholder interests, and spread the wealth by giving lower-level workers a share of the goodies.

These defenders claim that 10 million workers received options last year. That figure is overstated; the actual number is at most 3 million, or about 2 percent of US employees. But it's true that many blue-ribbon companies use options these days. Last year I conducted a survey of 150 companies listed on the New York Stock Exchange. Most of them (97 percent) offered stock options to employees. Not only in small start-ups but also in mainstream Corporate America, options are quite common.

However, the data also show that 62 percent of firms offering options pay them only to managers and then usually only to the upper crust. Only 4 percent of surveyed companies offered options to all employees.

So the case for exempting options from standard accounting rules cannot be made by asserting that options are a reliable way to share wealth with rank-and-file employees. The relevant question is whether options are a cost-effective mechanism for aligning executive behavior with shareholder interests.

It's undoubtedly true that the prospect of huge personal gain from cashing in options induces corporate execs to work hard at boosting stock prices. But this comes at a cost. Options have the potential for enormous dilution of shareholder equity. On average, stock equal to 16 percent of outstanding shares at US companies has been set aside for employee options. When those options are cashed in, they will significantly water down corporate earnings.

Moreover, nearly all option plans contain features that are not in the interests of ordinary shareholders. Harvard professor Lucian Bebchuk and his colleagues have shown that the plans are often structured to reduce or eliminate downside risk for executives who fail to build shareholder value. There is little or no pain for failing to produce gain; an option is merely repriced.

Also, the plans allow executives to reap huge rewards when stock-price gains are merely ephemeral – a one-day blip on a declining trend – or when gains are the result of general market or industry conditions.

Fed chairman Alan Greenspan recently faulted stock options for being "poorly structured." It is not, said Mr. Greenspan, that business people are any greedier than before. Rather, "it is that the avenues to express greed [have] grown enormously." The prospect of reaping huge windfalls on share-price movements is one reason we've seen such a disturbing uptick in unlawful shenanigans at US companies.

Coca-Cola has announced it would voluntarily expense stock options so that its corporate earnings reflect outstanding commitments. But few other companies are expected to follow suit. In most cases it's too risky for a company to stick its neck out like that. That's why government action is needed.

Long before stock options existed, America had one of the world's most entrepreneurial economies. Subjecting stock options to standard accounting rules will not deter entrepreneurship or harm shareholders. But it will remove an incentive for unbridled greed.

• Sanford M. Jacoby is professor of management, history, and policy studies at UCLA.

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